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Fiscally-credible John McDonnell has undermined George Osborne’s crumbling financial plans

You’re likely to have seen and heard a lot of nonsense about John McDonnell’s newly-unveiled economic policy. Ignore anything that criticises him because he’s got pretty much all of it right.

In case you don’t know what he’s saying, let’s boil it down into four bullet-points, courtesy of Richard Murphy’s Tax Research UK:

Labour will borrow to invest.

Labour will balance current spending with revenue in ‘normal times’.

But we are not in normal times at present. As a result, monetary policy does not work and so there is no choice but use fiscal policy and so run a deficit if the economy is to be kick started again.

Options one and three are both designed to stimulate growth that will increase tax revenues, meaning that in combination they should result in debt as a proportion of GDP reducing not in absolute terms necessarily, but as a proportion of GDP and so in terms of affordability over a rolling five year period.

Do you understand all that?

Firstly, it makes perfect sense to borrow at the moment because interest rates are at an all-time low – especially for government. The fiscal multiplier – the increase in national income due to government spending – is more than one at the moment, meaning there is a very definite gain to be had.

Secondly, flexibility is built into this – it accepts that rigid rules don’t work (and incidentally flings Osborne’s fiscal charter to the winds).

Thirdly, it explains why George Osborne is foolish to aim for a budget surplus by cutting spending (although we all know – don’t we? – that this is not his intention and he is simply shrinking the state).

Fourthly, it pre-empts criticism by explaining why debt may reduce in terms of affordability while appearing not to do so in absolute terms – meaning Tories would be silly to criticise on the grounds that the amount of debt hasn’t dropped; the proportion of debt will have done so.

Critics in the Labour Party have suggested McDonnell’s plan is similar to that of Ed Balls. Mr Murphy disagrees – and you can see his reasons on the Tax Research UK blog site.

Over in the New Statesman, Paul Mason expands on the possibilities of Labour running an overall budget deficit. He writes:

A Labour chancellor will have to show at every budget, according to Office of Budget Responsibility (OBR) calculations, that s/he can balance the books in five years’ time.

This applies only to current spending, not investment spending;

Therefore it’s entirely possible that Labour will run an overall budget deficit;

At the end of the parliament, debt will have to be lower as a percentage of GDP than at the beginning.

Academics Simon Wren-Lewis and Jonathan Portes explored in a paper (pdf) how a rule might optimally be designed to keep this under control, for a left government that believes in tax as the source of investment spending and redistribution. McDonnell has largely followed their conclusions.

The basic concept is to target the deficit on current spending over a rolling five-year period. This allows governments to respond to minor shocks by running a deficit now, while trusting to stimulus policies – higher spending, lower taxes, currency depreciation and lower interest rates – to correct the economy so that growth begins and borrowing to pay for current spending ceases.

The biggest commitment McDonnell is actually giving is on debt: that it should be lower – as a proportion of GDP – at the end of a parliament than at the beginning.

This is significantly more than George Osborne achieved: Osborne took the debt from 54 per cent in 2009-10 to 78 per cent of GDP on the last OBR report.

Mason goes on to provide this opinion on the plan:

The current Labour leadership is determined to root its social justice policies in real growth, not financial froth. Today’s policy change reflects that, and McDonnell said it loud and clear in the speech.

Mr Mason also disagrees with McDonnell’s critics, claiming that McDonnell’s fiscal rules are the first set that “include a contingency plan for severe crisis”.

Both he and Mr Murphy see the announcement as a clear signal that a future Labour government will rely heavily on state-directed investment (industrial policy).

McDonnell himself told The Guardianthat his announcement had been extremely well-received by both employers and workers:

“This has been welcomed this morning by [people] right across the business sector, business leaders, entrepreneurs as well as trade unions. The wealth creators have welcomed it,” he said.

“I woke up to the support of all the major representative bodies of business, and at the same time, the Independent, the Morning Star, right the way across the political spectrum have actually endorsed my approach to the new fiscal credibility rule.

“It demonstrates that if you’ve got that support from that broad spectrum, from the left to the right, from the communist party Morning Star to the CBI [Confederation of British Industry], you must be doing something right.”